Luke Hickmore and James Athey, investment directors, abrdn, consider the UK’s economic indicators and how this may affect where investors place their money, notably whether bonds will come back into play.
The IMF is the latest voice to add to the chorus of gloom around the outlook for the UK economy – the UK is now predicted to be the only major economy that will fall into recession, with even Russia forecast to experience more growth.
The reasons for the UK’s predicament have been well discussed: productivity, vacancies and investment levels have all dropped following both Brexit and Covid. In addition, the strong post-Covid consumer recovery, plus soaring energy prices ratcheted inflation up to levels not seen since the 1980s and the Bank of England is now on a rate-raising mission to bring it down again before high prices and high wages become entrenched.
Although energy prices have fallen and the economic outlook may not be quite as dire as predicted, we still believe that the economy will contract, which has yet to be fully reflected in earnings expectations, as well as equity and credit valuations.
But at some stage within the coming months, spreads will widen, equity prices will drop and government bonds will rally as the more usual positive correlation between equity prices and bond yields reasserts itself . However, we are hopeful that the recession that follows won’t be a deep one and we do expect to see an opportunity to add risk over the first half of the year.
Ultimately, 2023 should see positive returns from investment grade and high yield markets, as well as global rates markets. So, after the brutal year that was 2022, there is certainly an expectation that 2023 may well be ‘the year of the bond’.
Currently, markets are contending with the most aggressive tightening in policy rates in living memory, alongside extremely elevated inflation. Government bond yields are at their most attractive levels for years and we think it would be remiss to ignore the significant economic fragilities that have built up post global financial crisis, as central bank balance sheets have ballooned, forcing investors into ever riskier asset classes, while supporting anaemic recoveries in many G10 economies.
This fragility will likely resurface in dramatic fashion over the coming quarters. The inverse relationship between risk markets and government bonds (when equities go up, bond values go down and vice versa) has been badly damaged, but it is not permanently broken and could be reinstated this year. So, our appetite for global government bonds and duration is steadily increasing.
As economic growth collapses, we should see a bid to government bonds as investors rush to safe haven protection, followed by a bid for short-term bonds, as central banks signal a pause in rate hiking. However, central banks will be wary of easing and causing another inflation spike.
We would expect slower economic growth and lower inflation to be positive for government bonds, but not so for riskier assets over the coming months, although riskier assets may offer an attractive opportunity as the year progresses.
So, how will this play out in the UK? Well, this may be the first ‘normal’, interest-rate-led recession for 15 years and it should result in higher rates slowing the business cycle, inflation falling and then lower rates coming back into play to boost the business cycle once again.
But we do have some abnormal risks: if inflation remains elevated, we will have stagflation. This won’t allow rates to come down and the recession will be deeper and more protracted.
There is more risk of this happening in the UK because inflation here is higher than in the US and the EU and risks becoming entrenched. The UK is now functioning quite like an emerging market country: growth is very weak and the currency is falling, although there has been a recent pullback.
From an investing and asset allocation standpoint, what’s the best way to deal with the coming year? Wherever you look, there are lots of risks in the UK. First of all, for UK equities, nothing about the year ahead looks positive here, but at least UK equities are cheap. Much doom and gloom is priced in, but not necessarily all of it.
Cash is an attractive asset to hold as part of a diversified portfolio. It yields more than long-dated government bonds in most cases, is truly risk free and it gives optionality – the ability to be deployed quickly into cheap asset opportunities when they arise. Holding a proportion of cash and a proportion of treasuries is currently a good plan. Gold and index-linked gilts are also good allocation options.
Investing little and often and diversifying may well be the way to go in the year ahead. The good news for 2023 would be a ‘normal’ recession. But investors have a lot to navigate and there’s no easy call as to where to put your money.
